Anyone with any knowledge of the energy constraints facing the modern industrial world understands that alternative energy is essential for the future of any modern society. Two critical raw materials for the key alternative energy technologies are rare earths and polycrystalline silicon (“polysilicon”). China is already virtually the sole supplier of rare earths to the world and it is heading towards doing the same for polysilicon. The reasons have little to do with supply of material, but are related almost exclusively to the peculiar way primary industry operates in China. What is occurring is an exchange with few benefits to either side.

Much has been written recently about the export of rare earth minerals from China. There are two areas of dispute. The first is quotas imposed on exports. China justifies these quotas on resource conservation and environmental grounds. The U.S. disagrees and has threatened to challenge these quotas at the WTO. The second in the accusation in October that China cut off shipments of rare earths to Japan in retaliation over the Diaoyu Islands dispute. China denies that such a ban occurred, but there is much evidence on the other side.

All of this has raised alarm bells in the West. This is because rare earths are an essential component in many high-tech products. For example, the rare earth neodymium is required for the batteries used in the engines of most current electric vehicles and in the generators of most wind power generators. China accounts for about 95% of world rare earth exports. It therefore appears that the West has placed its technological future in China’s hands. The thought of China wielding this monopoly in rare earths on the lines of OPEC is not a pretty picture for Western businesses and governments.

There is, however, a much deeper story.

China’s peculiar situation with respect to rare earths is not a sign of strength. It is actually a sign a fundamental weakness within the Chinese system. This weakness, however, has a highly destabilizing effect on the world economy. The effect is being felt now with rare earths. A similar phenomenon will occur soon with polysilicon.

I will discuss both below.

Here is the basic story for rare earths. Despite the name, rare earth deposits are well distributed around the world and are not particularly rare. Processing of rare earths results in a high level of environmental pollution, arising from both the initial mining and also from the subsequent primary processing of the ores. Any mining operation that properly deals with these pollution issues results in a high priced product.

China has been able to dominate rare earths production by producing product at a remarkably low price. The China price is about one quarter of the price that had previously prevailed in the rare earths market. China achieved this low price in three ways. First, the Chinese producers make only minimal efforts to deal with the environmental impacts of the mining process. As a result, the rare earths mining regions in Inner Mongolia are classified as some of the most polluted regions in the world. Second, rare earth mines pay low wages and provide little or no health or safety protection to miners. The resulting poverty and health problems for the workers are well known. Third, rare earths mining has traditionally been conducted by numerous small operations. These operations ruthlessly bid against each other on price terms. This “ruinous competition” results in a price that barely covers the cost of production. Though China has recently pushed to consolidate the mining in fewer and larger companies, there are still a sufficient number of players so that the intense price completion continues.

What is the result for China?

China takes the pollution, low wages and health risks and keeps that in China. China then exports the resulting product at a fantastically low price to foreign high tech companies who reap the benefit. The real value of rare earths lies in the downstream use of rare earth minerals in the high tech production process. This technology remains almost entirely in the hands of foreign companies. Very little has been transferred to China. It is the usual story: China does the dirty work, takes the environmental and labor consequences and reaps no reward either in terms of profit or in terms of technological advancement.

This is hardly a sign of strength. It is an indicator of incredible weakness.

It appears that the West is the absolute winner in this exchange. However, there is a hidden problem. Economists I have talked with estimate that the “Chinese price” for rare earths is about &frac14; of the price that would result from an environmentally sound, worker friendly, profitable operation. This means that the “real” price of rare earths is about four times higher than the current China price. An entire set of “green” industries have grown up over the past ten years in reliance on that China price. The danger is that as the China price is phased out, many of these green industries will prove to be unprofitable. A primary example of this risk is the electric car. Since the China price for rare earths is virtually certain to be phased out very quickly, this risk is quite real.

A similar process is occurring right now in the market for polycrystalline silicon (“polysilicon”). Polysilicon is the fundamental raw material for the current generation of solar cells and related silicon based electronic products. As the use of solar energy boomed in Europe in the past decade, the price of polysilicon spiked. The price rose from about $35 per kilo in 2005 to over $450 per kilo in 2008. This increase in price attracted a substantial amount of Chinese investment in polysilicon production.

In 2001, China had only two manufacturers of polysilicon, with a total production capacity of 80 metric tons. By 2008, this number had increased to 19 makers with a capacity of 30,000 metric tons. With domestic demand at 17,000 metric tons, this produced substantial overcapacity in the Chinese market.

By 2011, capacity is expected to increase to 100,000 metric tons. This amount is about double the entire projected world demand for 2011. The result will be predictable: the Chinese manufacturers will engage in ruinous price competition. The price will fall dramatically. Worldwide, competitors to the Chinese will be driven out of business. Within China, none of the Chinese manufacturers will make any money. However, the process will continue even though no money is made, because the manufacturers are not private enterprises. They are owned and controlled by provincial and local governments, each of which jealously guards these precious investments and none are permitted to go bankrupt. Thus, the normal market correction resulting from falling prices does not occur in China. Instead, overcapacity is maintained, prices are reduced, and pollution, waste and worker conditions are simply ignored.

This is the “price” of the China price.

The resulting story for polysilicon will therefore be the same as it has been for rare earths. The production of polysilicon is energy intensive and highly polluting. Since China must import about 90% of the silica sand raw material, the opportunity for profit is even more constrained. Thus, China will export the clean end product to the west at ruinously low prices. Little or no technology transfer will occur. China will be left with the pollution and waste and little else to show for its efforts. The risk to the West will be that it will have lost most or all of its capacity to produce a critical source material. We will then be hearing the same concerns that China has a lock on the product and is using that monopoly for political purposes.

So what you’re saying is that China acts like a monopoly. Econ 101: It undercuts every other country’s mining companies by pricing below their costs (ie you said some of these companies are kept alive through local government subsidies). China thus pushed other countries out of the market and gaining control of the market and then jacks the price up (when no other competitors exist).
We have laws in the US to stop companies from doing that. The WTO is supposed to stop countries from doing that.
If the WTO doesnt take action, then where does that leave the US? Nobody wants to see trade sanctions, but what else can the US do?

http://www.twitter.com/darnoc darnoc

Great analysis Steve. This is great context for those that suggest breaking Chinese monopoly control over rare earths is as simple as starting up new ventures outside of China. Consider that the total rare earths concentrates market is currently somewhere around $1B globally…yet at least five major projects (3 in Australia and 2 in North America) have announced required financing plans in the past two years…required financing of between $500MM and $1B each. Ore concentrates are also fairly low on the value chain…there’s plenty of capital investment required after this point to produce pure metals required for rare earth metals supply into hi-tech products. The mix of trade-offs between capital investment, pollution, worker comp, etc makes for an interesting soup indeed….and one that I daresay is poorly understood by many of the investors rushing into the rare earths game.

http://www.meubles-cuisine.net/cuisiniste-suisse-maroc.php cuisiniste

china will soon rise the yuan and will soon have enough cash to launch a second wave of industries whith the aim of protecting it’s own environment and also it will export this industries to the rest of the world.

Twofish

John: If the WTO doesnt take action, then where does that leave the US? Nobody wants to see trade sanctions, but what else can the US do?
WIth regard to WTO, there is currently a case before WTO regarding whether China’s export quotas are valid under international trade law. The nice thing about WTO is that this is a case in which a lot of different countries have different interests, and it’s not just US versus China. For example, Saudi Arabia and the major oil producers are taking a *VERY* strong interest in this case, because obvious they have a very strong interest in the outcome of this case.
One reason WTO works is that WTO cannot force a nation to do anything. WTO cannot force China to remove rare earth export quotas. However, this is important because WTO cannot force the US to do anything either. What WTO can do is that if it rules that the export quotas are inconsistent with international trade law, it can and will authorize other nations to take countervailing action. So if WTO rules against China and China decides to keep export subsidies, then WTO will authorize the US and Europe to do something to balance the trade system.
In fact, this happens rather rarely. China sometimes wins cases in the WTO. It sometimes loses cases in WTO. In every situation where China has lost a case so far, it has changed its laws to comply with the WTO ruling because thus far, the consequences of changing its laws were less than having countervailing tariffs.
A good example of this was the WTO ruling that China could not deny copyright production to censored books and movies, but that it was legal under trade law to censor books and movies. China then rather quickly changed its copyright law so that you can now copyright a banned book in China, because the cost of changing the law was less than the benefits. Now had WTO ruled that censorship was illegal under international trade law, China would have likely preferred to have WTO authorize the US to impose sanctions. However, there’s a balance since that because WTO knew that if it started getting into censorship law, China (and a lot of other countries) would start ignoring WTO, the panel decided to say explicitly that censorship is allowed under international trade rules.
The examples in which a country will simply ignore a WTO ruling and take sanctions is small but it exists. But the fact that a country can ignore WTO if it thinks is necessary is one reason why WTO works, and why most of the time countries do comply with WTO.
Also WTO is a good example of international law that works, and works well.

Twofish

One point. I try very hard here to avoid using the terms “legal” and “illegal”. I do this in large part because the WTO panels do not use the term “legal” and “illegal” in their decisions. There is a reason for this. If you call what someone is doing “illegal” then this implies what they are doing is “immoral” and you can and should use shame and peer pressure to get them to stop. One reason WTO works is that everyone has agreed that people *NOT* use shame and peer pressure as a means to enforce WTO rulings, so WTO goes out of its way to use the term “consistent” and “inconsistent.”
One thing that you have to be careful to do is not to make something into a nationalistic urination contest if you don’t have to, since if people start talking about “winners” or “losers” as if this was a football match, it makes it harder to get things done. If a WTO dispute resolution panel rules for you, you are much more likely to get someone to accept the decision if it is just business, rather than if you start saying HHAAAAHHAA!!!! WE WON!!!! YOU LOST!!!! YOU BAD BAD BAD COUNTRY!!!! NOW CHANGE YOUR LAWS!!!!!
One thing that is curious is that the rare earths case has been around for a year, and no one noticed.
John: It undercuts every other country’s mining companies by pricing below their costs (ie you said some of these companies are kept alive through local government subsidies.
It actually doesn’t. Chinese mines have extremely low costs. Chinese mining is cheap because Chinese labor is cheap and its has relatively few safety standards. Also China is arguing under Article XX that the export quotas it puts on rare earths are legal under WTO rules because theyhttp://www.wto.org/english/docs_e/legal_e/gatt47_02_e.htm
(b) necessary to protect human, animal or plant life or health; and
(g) relating to the conservation of exhaustible natural resources if such measures are made effective in conjunction with restrictions on domestic production or consumption;
Arguing that Chinese export quotas reduce environment damage in China helps it argue XX(b). However, the US will likely try to argue that those quotas are not valid because China is not imposing restrictions on domestic use of rare earths. At this point you get into a long and nitpicky argument over specific regulations.
The other thing is that the outcome of a case is more than “US wins” or “China wins”. The logic of that the panel uses is extremely important. I think it’s *extremely* unlikely that the WTO will outlaw OPEC or tell the Saudis that they can’t put quotas on oil production. So part of the game for the US lawyer is to come up with some argument that makes OPEC valid while making the Chinese exports valid, whereas the Chinese lawyer is going to argue that “since what OPEC is doing is obviously OK, what we are doing is also OK.” At this point, you get nitpicky and go into the details of the specific rules.
Also, I’ve heard this explanation of Chinese actions, and it makes sense to me. What happened was that China imposed export quotas, and the price of rare earths increased dramatically. This gives lots of opportunity for smuggling. You buy non-quota rare earths and then illegally sell them. Around the time the Japan thing happened, customs released that there was a lot of smuggling and did a crackdown, and this is why shipments seemed to go down.

Twofish

Also, one other reason why the “WTO works” is that you have a lot of different interest groups, each with different interests, and a lot of the interest groups are cross-national. For example, the issue of Chinese rare earths is a really big case, because you have a lot of third party nations interested in the outcomehttp://www.wto.org/english/news_e/news09_e/dsb_21dec09_e.htm
The case numbers are DS394, DS395, DS398. This is a big case, and it involves more than rare earths and more than China. It’s also been going on for at least a year.
Also you have some “strange bedfellows.” For example, if I were a rare earth mine operator in the United States, I’d want China to *win* this case. If China loses, then cheap rare earths keep going onto the market, and I can’t make money from my non-Chinese mine.
If I were a steel worker in the US, I’d want China to *lose* this case and then refuse to implement WTO judgement. Since I’m a steel worker, I couldn’t care less about rare earths, but if China loses and then refuses to implement, WTO will authorize the US to impose sanctions such as restrictions on the import of steel.
Also, one thing I do find remarkable is that no one in China seems to care about this issue. Something that is happening in the US, is that people in the US are afraid of the future, and so whenever China coughs, you have just this huge emotional reaction. What I find interesting is that no one in China seems to care about rare earths. It’s just not an emotionally important issue. It’s not even a “HA!!! HA!!! We are better than you issue.” Something that worries me about Steve’s article is that if there are a lot of similar articles in the US, then it could complicate things by making a non-nationalistic issue that no one in China cares about, into an issue that people do care about.
The other thing that I find interesting (and I have a paper that summarizes the mood of Chinese foreign policy experts) is that people in China tend to be a lot more optimistic about the future of the United States than people in the United States. The general consensus of people in China both at the elite and mass level is that the problems the US are facing are just a temporary economic blip, and that in a year or two the US will bounce back. One reason people tend to believe this was that people were burned before. In the 1990’s, there was a general belief in China that the US was a power in decline, and foreign policy experts in China were pretty shocked by the fact that the US was willing and able to defeat Serbia in the Kosovo War in 1998.
Finally, don’t make a mountain out of a molehill. With all of the talk of this giant trade confrontation, it’s important to remember that trade wars aren’t bullet wars, and no one has died and no one is likely to because of anything that is going on.
I remember during the Hainan island incident, during a period in which US-China relations were really bad (i.e. people were throwing stones at the US embassy), in which someone mentioned that the US and China will never be “friends” but if you can get things to the point where people are arguing over the price of cotton underwear rather than anything in which someone is going to die, then we have made a lot of progress. I’m getting old, and one thing that I remember is how really bad things where during the Taiwan straits crisis or the Hainan island incident.
This rare earth stuff is nothing, and it’s part of how good things are going that people are making a big deal over something that’s pretty trivial.

Twofish

Also, let me mention what I’m *really* worried about…….
The thing that China has done which I think is a good thing for China is to pour money into science research in green energy. The thing that I am worried about is that the incoming Congress will cut funding for science and technology. Science is your classic “big government” program, and “big government” is something that seems to have fallen out of favor.

Nate

Have you sent a copy of this to Wen Jiabao?
John:
From what I understood China would operate as a monoply when cutting prices. But because of the massive overcapacity controlled by many small companies that are willing and able to operate at a loss, it would be unable to raise prices without first consolidating the industry.
Twofish:
Your comment is longer than the post.

Jerome Cole

Twofish: I think you are deterring other people from contributing. Even if your are not the static-to-noise ratio on your comments is very high.

Elemental

What is happening with rare earths is both a precursor and a symbol of our entire relationship with China. What you say about rare earths is equally true of what you are always referring to as the “rubber ducky” type product. The only difference is that ceding the making of rubber duckies to China (as we have done) is, at least standing alone, much less of a threat to our national security.

Page Nelson

I want to thank Steve Dickinson for this article, which is both very well written and informative on both a factual and speculative level. I have been following the Rare Earth Minerals situation for six months, reading dozens of articles, but this is one of the two or three best–for analysis it is the best.
I offer this praise because only this article has given an explanation of the prolix mechanics of the Chinese REM industry, an explanation which offers insight into the recent bizarre-seeming actions by the Chinese authorities. The single most valuable point here (from my point of view) is the observation that the Chinese companies, being state controlled, have no incentive (like shareholder demand) that they cease flooding the market with their dirt. In China it s a race to the bottom.
The interesting thing to see now is whether or not the resurgent REM mining production efforts outside China (US, Australia, Canada, etc) will be properly supported (protected) as the strategic materials they, in fact, are. If the price should be 400% above the current Chinese export price, so be it. Prices should reflect all aspects of a commodity’s production. In the world of commodities, price spikes many times higher than that are routine. But any attempt by China to undercut these industries (Molycorp, Lynas) again, as part of policy, must be rebuffed.
Perhaps the Chinese government is waking up to the absurdity of allowing their system to rob their product of most of its potential value. The lessons of OPEC in 1973 might apply.

Dan (another Dan)

This is a good article. The only thorn in my eye is whether this situation is a strength or weakness for each country. I can’t tell, because these type of transactions, natural resources, costs, etc. have been like that for quite a while. Foreigners, or natives don’t necessary control the entire situation, there is a balance (although shaky) between the two. Things have always been this way. So, we’ll have to wait and see in this case what will happen.

Twofish

Nelson: The single most valuable point here (from my point of view) is the observation that the Chinese companies, being state controlled, have no incentive (like shareholder demand) that they cease flooding the market with their dirt
That’s actually not true. State owned companies in China are expected to make a profit, and the smaller state owned companies are controlled by local governments that do not have the financial ability to subsidize them, and count on the companies to make a profit.

http://chinacopyrightandmedia.wordpress.com Rogier Creemers

Just two points on the WTO analysis:
1: “We have laws in the US to stop companies from doing that. The WTO is supposed to stop countries from doing that.
If the WTO doesnt take action, then where does that leave the US? Nobody wants to see trade sanctions, but what else can the US do?”
The WTO is not supposed to do anything. It has no competence whatsoever to initiate rulemaking / revision, it also has no competence whatsoever to call member states to heel. The only thing the WTO does, is provide a Dispute Settlement Body which says whether member states’ measures are consistent with their WTO commitments or not. Usually, this is followed by a round of negotiation and a mutually agreed solution, otherwise, the WTO will authorize countervailing measures. Also, in itself not necessarily a punishment, depending on the relative size and industries concerned in both countries.
Most importantly: the WTO was not given any right of initiative at the behest of the major trading nations of the time, which were reluctant to transfer any sovereignty to this body. Therefore, especially from the US, calling upon WTO activism now strikes me as not only a factual fallacy, but also as hypocrite.
2: (and connected), “Now had WTO ruled that censorship was illegal under international trade law, China would have likely preferred to have WTO authorize the US to impose sanctions. However, there’s a balance since that because WTO knew that if it started getting into censorship law, China (and a lot of other countries) would start ignoring WTO, the panel decided to say explicitly that censorship is allowed under international trade rules.”
Nonsense. For starters, WTO regulation expressly authorize censorship (Art. 17 Berne Convention, implemented by Art. 9 TRIPS). Moreover, in the report to China – Audiovisual Products, the Panel expressly stated that books already passed through censorship were not like products with books that weren’t.
It seems to me that very often, we confuse what the WTO says with what we would like the WTO to say. In reality, claims must be brought on a (usually very specific) legal basis. And one thing: did you know the US is the one country with the longest WTO history of continuous incompliance? 10 brownie points for who guesses on which case.

pete

It seems China is treating rare earths in a similar way to coal. Making coal at a loss (once pollution and accidents are factored it) is smart – it drives down the cost of manufacturing, making China just about unbeatable as a low cost manufacturer. But low quality coal is stationary – you have to burn it close to the mine, or transport costs will be too high. High quality rare earths can just be shipped off, so you don’t get the jobs (and technology) from the industries down the chain.

http://prestonrhea.org/ Preston

I am interested in the implications of the end of cheap REM for the cleantech / “green” industry. As Steve writes:
“An entire set of “green” industries have grown up over the past ten years in reliance on that China price. The danger is that as the China price is phased out, many of these green industries will prove to be unprofitable. A primary example of this risk is the electric car. Since the China price for rare earths is virtually certain to be phased out very quickly, this risk is quite real.”
Question: was there a comparable underpriced “catalyst” in the product and manufacturing chain one hundred years ago which enabled the market boom of the internal combustion engine and, as a result, automobiles? If so, why and when did that catalyst – be it a process or a material – rise to its “true” price and what was the implication for the automobile industry?
My hope is that, since the automobile industry has been successful over the past century, perhaps a similar fate can be enjoyed by the cleantech industry despite the demise of “China-priced” REM.

Twofish

Roger: Nonsense. For starters, WTO regulation expressly authorize censorship (Art. 17 Berne Convention, implemented by Art. 9 TRIPS).
The trouble with involving Article 17 Berne is that the US could (and apparently did) argue that those provisions were overridden by China’s accession agreement and it’s commitment to provide national treatment.
It appears that China did not invoke Article 9 TRIPS, but rather invoked Article XX(a), which is the public morals exception.http://www.wto.org/english/tratop_e/dispu_e/cases_e/ds363_e.htm
Roger: And one thing: did you know the US is the one country with the longest WTO history of continuous incompliance?
Yes. In fact I did :-)
Roger: 10 brownie points for who guesses on which case.
So many to choose from. Cotton. Bananas. Internet gambling. Cuba…..

http://none Michael

I heard that the Chinese government IS trying to reap some of the benefit of being the world’s supplier of rare earths, by forcing buyers to move some of their production facilities to China. And I am sure that buyers are thinking along those lines anyway, especially now since China has shown it may limit exports
The second thing is concerns the silicon. Which process are they using to refine the silicon? This is important because silicon for use in photovoltaics and semiconductors has to be extremely pure. The Siemens process, which has been used up till now, is very energy intensive, but there are other companies trying a new, cheaper process. If the Chinese bet on the wrong process, it may not be even worth them keeping their factories open. As well, solar seems to be moving to thin film, which does not use silicon and, again, this may increase overcapacity.
This may all be due to Chinese subsidies in mining and hi tech. Just as an example, there are also subsidies on grape wine in China. As a result, 97% of Chinese wine is absolutely god awful and the rest isn’t very good.

http://www.easybuyall.com CJS

China will soon increase the value of the yuan and then will soon have enough cash to launch a second wave of industries aimed at protecting its own environment and at exporting additional products to the rest of the world.

HY

About polysilicon, China manufactures 40,000 metric tons and imports 37,000 metric tons in 2010. The production in 2011 is estimated at 60,000 metric tons. China is not overcapacity in terms of polysilicon production. They still rely heavily on imports in the next few years.

Steve,
Great post. Really is the best on the topic. Any updates planned?

VO5

Do you agree with those who see this whole issue disappearing within five years because the rest of the world will have reinvigorated their own rare earths mining? If that happens, I presume you will also agree this will prove to be yet another case of China having gotten too big for its own briches.

Sadeky

Did you see Joe Sternberg’s recent WSJ article where he says China’s actions on rare earths will end up hurting China substantially in the long term? Do you agree?

Valerie S.

I hate to just repeat what everyone else has said, but this really is a very clear and helpful report.

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